Points paid for refinancing your mortgage may be deductible under certain circumstances. So ruled the U.S. Court of Appeals for the 8th Circuit earlier this month.

The appellate court overruled the U.S. Tax Court, and permitted the taxpayers to deduct the points that they had paid in the year that the refinanced loan was obtained, rather than as the Tax Court had required that they be deducted over the life of the loan. Each point paid to get a mortgage is equal to 1 percent of the loan.

Zenith Annette and James Huntsman purchased a principal residence in Stillwater, Minn., in January 1981. The residence was partly financed with a $122,000 loan.

The note was payable in monthly installments with the balance -- a balloon -- to be paid in January 1984. In July 1982, the Huntsmans financed a home improvement with a loan of about $22,000, which was secured by a second mortgage on the property.

In September 1983, they refinanced their residence with a new 30-year loan, and the proceeds were used to pay off the notes secured by the existing first and second mortgages.

As part of the $148,000 refinancing, the Huntsmans paid $4,440 in points. This included a loan origination fee of $1,480 and a loan discount fee of $2,960, or a total of 3 points.

The Huntsmans deducted the $4,440 in points they paid on their 1983 tax return, but the Internal Revenue Service denied the deduction.

The Huntsmans petitioned the Tax Court, but in November 1988, that court held that the points they paid must be deducted "ratably over the life of the loan," rather than in the year that the points were paid.

The Huntsmans apparently are persistent taxpayers. They appealed the judgment of the Tax Court to the 8th Circuit Court of Appeals. And earlier this month the Court of Appeals reversed the Tax Court opinion, permitting the Huntsmans to take the full deduction for the points in the year they paid them.

Initially, the Tax Court took a very narrow view of the Internal Revenue law. Section 461(g)(2) specifically states that an earlier section that deals with a pro-rated deduction does not apply "to points paid in respect of any indebtedness incurred in connection with the purchase of improvement of, and secured by, the principal residence of the taxpayer... ."

Thus, where points are an established business practice in the area in which such indebtedness is incurred, and the amount of the points does not exceed the amount generally charged in the community, this section of the law seems to suggest that mortgage points are deductible in the year they are paid.

But the Tax Court didn't see it that way. It held that "in a refinancing transaction, the funds generated by the loans generally are not used to purchase or improve a principal residence but to pay off the loan that is already in existence and thereby lower the interest costs incurred or achieve some other financial goal not connected directly with homeownership. Therefore, we hold that the exception ... does not apply to points paid on refinancing transactions and that, if such points are otherwise deductible, they are deductible ratably over the life of the loan."

The appeals court disagreed with the Tax Court's reasoning. The appeals court looked at the Internal Revenue Code section, and concluded that it should be broadly construed. The appellate court was especially concerned with the meaning of the words "in connection with." According to the court of appeals, "we find a fair reading of the statute requires that the indebtedness need only have an 'association' or 'relation' with the purchase of the taxpayer's residence. The statute does not require all indebtedness to be directly related to the actual acquisition of the principal residence."

Accordingly, the court of appeals then concluded that the Huntsmans acquired their permanent mortgage to extinguish the short-term loans and complete the purchase of the home. "We conclude that obtaining the short-term financing was merely an integrated step in securing the permanent financing to purchase the home," the appellate court said.

According to the court of appeals, in this kind of situation, where taxpayers purchase a principal residence with a short-term loan secured by a mortgage on the residence, and subsequently replace the loan with long-term financing within the time period involved, "the permanent mortgage obtained is sufficiently in connection with the purchase of the home" to fall within the provisions of the Internal Revenue Code that permits the deductions.

This may be a small victory for consumers, but it is a major step in the clarification of this important issue of the deductibility of mortgage points.

Clearly, merely to refinance to obtain a lower mortgage rate would not give justification for deducting the mortgage points paid on that new refinanced loan. But if the taxpayer can demonstrate that the loan obtained was "in connection with the purchase or improvement of the principal residence of the taxpayer," the Huntsman case makes it clear that this language must be liberally construed.

Unfortunately, this opinion only assists taxpayers in Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. That is the limits of the 8th Circuit Court's jurisdiction.

No doubt the IRS will continue to press its negative view on deductibility of points in all other jurisdictions. At some point it may try to force another circuit court of appeals to take on a similar case, with the hope that a different opinion would be reached, thereby giving the IRS the opportunity to appeal the inconsistent opinions to the Supreme Court.

There are two important side aspects of this case that are worth mentioning.

First, the appellate court did not distinguish between the loan origination fee and the loan discount fee. Both were considered "points" for purposes for the court's analysis.

Second, the court made it clear that under any circumstances points are deductible. The only question in the Huntsman case was whether these were deductible over the life of the loan or in the year that the points were paid.

Many taxpayers who have refinanced often forget to consider deducting the points over the life of the loan. There is a legal deduction, albeit a small one.

This issue has not been decided. Perhaps Congress will give further relief to taxpayers, especially now that Congress is giving serious consideration to amending the tax code once again.

Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.